Market makers arouse suspicion

NYSE clarifies investigation into floor trading

DavidWeidner

NEW YORK (CBS.MW) -- A New York Stock Exchange investigation into questionable trading may not be as serious as first believed, but the damage to investor confidence could be hard to repair.

Late Tuesday, the NYSE took the uncharacteristic step of clarifying exactly what it is investigating.

Early reports said the probe focused on front running. In a front run, a specialist makes a trade in his own personal account before executing a big customer trade that is likely to move the market.

But the Big Board says the current probe is focused on violations of the "negative obligation" policy. It requires market makers to match buyers and sellers without getting in between them. Instead, some specialists may have bought the stock themselves from the seller and sold it to the buyer at a higher price, pocketing the difference.

"What they're describing is something very hard to monitor," said Ingrid Werner, an associate professor of finance at the Fisher School of Business at Ohio State University and former NYSE resident economist. "It can happen by someone trying to break the rules. It can happen accidentally.

"I don't think this is a crisis."

Specialists often use their own accounts to expedite the trading process when they are "swamped" with orders, Werner said. The resulting gains are often a penny a share -- though the gains can total thousands of dollars -- and don't have a direct impact on the customers.

"If front running is a crime, this is a misdemeanor," said Michael Goldstein, an associate professor of finance at Babson College. It's not the same level of severity. It's like using your cell phone on the road instead of driving drunk."

Indeed, the NYSE said it stumbled upon the questionable trading activity as part of its ongoing review of floor trades. The Wall Street Journal, citing anonymous sources, said the query had been initiated by customer complaints.

That said, the NYSE has taken another hit to its tarnished image. Last month Sanford I. Weill withdrew his name from consideration for a NYSE board seat after New York State Attorney General Eliot Spitzer objected. The scandals, coupled with the looming settlement with Wall Street's biggest banks, have sapped investor confidence. See full story.

Damon Kavelsky, a market analyst with Financial Insights, said the investigation could prove costly to the NYSE's reputation if the practice is found to be widespread.

"If this is just one or two brokers, this thing is going to blow over," he said. "If it's happening on a wider scale, there's going to be a call for reform."

Kavelsky said the NYSE statement issued Tuesday suggested that penalties and fines in the case, if anyone is charged, are likely to be lighter than in a traditional front-running case.

So far, the NYSE has declined to say which firms are the targets of the probe. There are seven specialist firms on the floor. FleetBoston Financial
FBF, -1.02%
has acknowledged it is responding to the inquiry. LaBranche
LAB, +0.00%
also is believed to be a target in the inquiry, though it only has said that its policy is to cooperate with investigators and Dutch firm Van der Moolen has confirmed it's being investigated as well.

But John C. Coffee, a finance professor at Columbia University, said the damage for the NYSE has already been done. Coffee expects new rules to come, but he says he expects reform will stop short of implementing the automated trading system that many market participants have long wished.

"This is an issue of semantics," Coffee said. "It's going to be embarrassing. The NYSE has said for 30 years that its market structure was superior ... more efficient. (Reform) is going to require some new, efficient market controls. We have to keep the financial intermediary on the sidelines."

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